John Maynard Keynes' central observation was that the economy is a closed loop: your spending is my income and my spending yours, and so forth. If someone chooses, for whatever reason, to spend less, the whole economy suffers by exactly that amount. The economy is big and can tolerate a little of this, but if we all do it at the same time, for example as a consequence of a bank run, we get a recession. Keynes called this "The Paradox of Thrift". Thrift is individually a good policy, but if everybody does it, it's a catastrophe.
Keynes formalized the earlier recognition by JP Morgan and others that a central bank can reduce the impact of these crises of thrift and provided a prescription: If savings are too high and business declining, we know that there's not enough demand in the economy, and inflation is necessarily low. You can stimulate personal and business spending by lowering interest rates--printing money, controlling interbank lending, a variety of mechanisms. If rates are low, people looking to start or grow a business can borrow cheaply, and people looking to invest will look for businesses to invest in rather than put it in something that pays minuscule interest. Similarly, if savings are too low and you fear a bubble which might pop, you can do the reverse: raising rates, withdrawing money, etc. investors will pull back from riskier investments and go with safer interest that's just as profitable.
The best way to do this is always to manipulate rates. Fiddling with the money supply creates inflationary pressure and people are terrified of that.
Nearly all recessions, and all depressions, are crises of
demand. People stop buying because they're afraid of something, and
that decline in demand propagates through the economy. By reacting
quickly and strongly enough, the central bank can prop up demand through a small
recession by cutting rates. But there are some recessions, such as the oil and grain crises of the 1970s, which are supply shortfalls. In these cases, the thing to do is to raise rates. This will lower demand, hopefully to fall in line with the supply. It's a slower process, because the changes in production need to propagate through the economy.
But there's a case where there's no further manipulation possible: if business is still declining and interest rates are already below inflation, further lowering can't work. People (i.e. banks) won't pay for the privilege of lending money. Keynes called this a "Liquidity Trap", or sometimes zero lower bound or "balance sheet recession". But as long as money is available for those low rates, business can still borrow cheaply. And therein lies Keynes most important insight: If banks won't do it, and businesses still want to expand, somebody else needs to step in. In 1907, JP Morgan and a few of his friends were able to do it, but he knew the days where that would be possible were ending. That somebody else can only be government.
It's impractical for government to set itself up as a lending bank for ordinary business, for a lot of reasons, so if government literally wanted to make money available to business, they'd need to go through the banks. But it's the banks that aren't lending, so giving them more money to not lend is unhelpful. (but the bankers themselves love it!) So government needs to go more directly to business and buy their products. Government has a great many needs for products: Roads, teachers, public safety workers and materiel, weapons, etc. Government, with its inherently perfect credit rating, can borrow for cheap and pour money into business. It doesn't matter much if it's only some businesses--those businesses and their employees buy from others and it pretty quickly is spread widely through the economy.
Demand crises, especially liquidity traps, all have a specific cause--a specific thing the banks and well-funded businesses are afraid of. In the case of the subprime crisis, about 10% of the $10T mortgage market was untenable: a shortfall of about $1T. A Keynesian stimulus therefore had to create at least $1T of demand for housing, which means about $3T of total stimulus after multipliers are factored in. The stimulus we got was spectacularly inefficient: most of it went directly to banks (who are still not lending). After multiplers, the three big bills (2008 TARP, 2009 ARRA and the 2010 "deal") and the three rounds of QE put under $1T into the economy and about $3T into banks and big businesses, for a net effect of about a third of what we needed, and a cost to taxpayers of about $1.5T. Many Keynesian economists were complaining about this at the time. (The crisis was actually mostly about leverage: those $10T of mortgages were leveraged over 5:1, which allowed bad mortgages to hide and created huge demand for mortgages, any mortgages, good or bad)
added 2 apr 13
A common misconception is that the money in circulation and the money supply are the same thing. They are not. Same thing with saving and investing. To most ordinary consumers, a savings account was all the investing they were ever likely to do, especially back in the days when such accounts paid interest. Investing actually involves doing something real with the money: building a house, buying new equipment for a business, starting a new business. This is the stuff that grows the economy. Putting money in storage (or investing in low, low government bonds) really isn't. The money that's actually being spent paying for stuff, including investing, is the only money that's in circulation. Parking money in savings really isn't. It's part of the total money supply. Only money in circulation is contributing to inflation. This is why QE and the three stimuli had no discernible impact on inflation. They did have a small effect on demand (very small, relative to the amount of money they cost), and they may have kept us from having deflation
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